It’s not how much money you make—it’s how much you keep. Investors in public companies learn early in the game that growth companies can double and sometimes triple their revenues during their early growth stages, but that does not mean they necessarily earn a profit.

Once a company does generate profits, it’s much easier for investors to determine its value. The percentage of a company’s revenues that are left after all its costs are taken out is known as profit margin.

Some very profitable companies generate $50 in profits for every $100 they generate in sales. That means they have a 50 percent profit margin. Some companies have $3 in profits for every $100 they have in sales. That’s a three percent profit margin. Which company is a better investment?

Comparing profit margins as a way to analyze companies and make investment decisions is an essential component of successful investing. But you need to know some ground rules:

  1. Make sure you are comparing apples to apples. In other words, don’t compare an operating margin (sometimes called a pretax margin) with a net profit margin (after taxes).
  2. More importantly, you shouldn’t compare companies in different industries. Every industry has its own set of profitability benchmarks. The real key is to compare companies in the same niche.

Food retailing is a notoriously competitive business, and as a result, profit margins can be slim. As a hypothetical example, two supermarket chains, A and B, compete intensely for business. Supermarket A is traded on the New York Stock Exchange. Supermarket B, while not publicly traded, files reports with the SEC because of the number of employees who own stock in the company.

Suppose the operating margins of the two companies over a three-year period of time as filed with the SEC were as follows:

OPERATING MARGINS

Company            Year 1    Year 2    Year 3
Supermarket A      1.5%        1.8%       1.7%
Supermarket B      4.8%        4.9%       4.0%

If Supermarket B were publicly traded, it is quite possible that its shares would be in higher demand than its competitor.
Why? In short, the tighter the margins, the less likely investors are to swarm around a stock, especially if the company is one of many and ranks in the middle of the pack.

Also, if a company’s profit margins are declining, you may see its stock drift lower. So, bottom line: Watch the bottom line. iBi